A debt fund is a type of mutual fund which predominantly invests in fixed-income securities such as government securities, corporate bonds, certificate deposit and other money market instruments. However, according to the Income Tax Act, any fund which invests less than 65% of its total assets in equities is termed as a debt fund.

How Debt Funds Generate Returns?

Debt funds generate returns in two ways. Firstly, by way of interest (coupon rate). The fixed income securities/bonds they hold feature a predetermined interest rate termed as the coupon rate. Secondly, the value of their bonds and other fixed income holdings changes due to economy-wide interest rate and credit rating movements. For instance, if a debt fund holds a Government of India Bond paying 8% interest, the debt fund will get the interest payments at 8%. Additionally, an RBI rate cut will also increase the value of the Government of India Bond which will generate returns for the debt fund.

What Are The Risks In Debt Funds?

Credit Risk: Risk of defaults on the bonds/securities held by the fund. This risk is typically assessed and rated by ratings agencies (for instance by assigning ratings like AAA, AA etc). If the chances of default in a particular bond increase, the ratings agencies downgrade the concerned bond, causing a decrease in the value of the debt fund holding it.

Interest Rate Risk: Risk of change in the value of the fund’s bonds/securities due to a change in the interest rates. In the event of an increase in the interest rate, the value of the debt fund falls and in case of a decrease in the interest rate, the value of the debt fund rises. The exact amount by which a debt fund’s value will rise or fall is given by an indicator called ‘Modified Duration’. This indicator gives you the percentage change in a debt fund caused by a percentage change in interest rates. For instance a modified duration of 3 means that a 1% rise in interest rates in the economy, will cause a drop in the value of concerned debt fund by 3%.

Liquidity Risk: Risk of the fund manager being unable to honour redemptions due to illiquidity in the debt securities held by the fund.

Types of Debt Funds

Overnight Fund: An open-ended debt scheme which invests in overnight securities having maturity of 1 day. Since, this fund comes with a maturity period as short as 1 day, it possesses very little interest rate fluctuation risk and credit default risk.

Liquid Fund: An open-ended debt scheme which invests in debt and money market securities with maturity of up to 91 days. Investors who wish to park their idle money for a short period of time, bearing the least amount of risk, should go for liquid funds. Liquid funds generally give returns higher than savings accounts but similar to fixed deposits.

Ultra Short Duration Fund: An open-ended debt scheme which invests in such debt and money market instruments such that the Macaulay Duration of the fund is between 3 to 6 months. These funds generally offer returns higher than bank fixed deposits and involve a relatively low amount of interest rate risk.

Low Duration Fund: An open-ended debt scheme which invests in debt and money market instruments such that the Macaulay Duration of the fund is between 6 to 12 months. These funds generally offer returns higher than bank fixed deposits and involve a relatively low amount of interest rate risk.

Money Market Fund: An open-ended debt scheme which invests in money market instruments having maturity of up to 1 year. This fund provides investors with liquidity and relatively low risk of principal by investing in relatively low-risk short-term securities.

Short Duration Fund: An open-ended debt scheme which invests in debt and money market instruments such that the Macaulay Duration of the fund is between 1 year and 3 years. Considering the maturity period, these funds provide relatively low returns but also carry low amount of risk.

Medium Duration Fund: An open-ended debt scheme which invests in debt and money market instruments such that the Macaulay Duration of the fund is between 3 years and 4 years.

Medium to Long Duration Fund: An open-ended debt scheme which invests in debt and money market instruments such that the Macaulay Duration of the fund is between 4-7 years.

Long Duration Fund: An open-ended debt scheme which invests in debt and money market instruments such that the Macaulay Duration of the fund is more than 7 years.

Dynamic Bond Fund: An open-ended debt scheme which invests in debt schemes of dynamic nature (in terms of their composition) and of varying tenures. These funds are ideal for investors with 3-5 years time horizon and moderate risk appetite.

Corporate Bond Fund: An open-ended debt scheme which invests at least 80% of its total assets in highest-rated corporate bonds. These funds are capable of providing high returns and also carry a low amount of risk by investing in high-rated instruments.

Credit Risk Fund: An open-ended debt scheme which invests at least 65% of its total assets in corporate bonds with credit rating below the highest rated corporate bonds. These funds are typically capable of generating 2-3% higher returns compared to risk-free instruments. They also carry a higher level of risk.

Banking and PSU Fund: An open-ended debt scheme which invests at least 80% of its total assets in debt instruments of banks, public sector undertakings (PSUs), and public financial institutions.

Gilt Fund: An open-ended debt scheme which invests at least 80% of its total assets in government securities across maturities. Since, this fund predominantly invests in government securities, it carries no credit risk. However this type of a fund carries a high level of interest rate risk.

Gilt Fund with 10 year constant duration: An open-ended debt scheme which invests at least 80% of its total assets in government securities such that the Macaulay Duration of the fund is 10 years.

Floater Fund: An open-ended debt scheme which invests at least 65% of its total assets in floating rate instruments. This type of fund has a low level of interest rate risk because the instruments it holds have their rates periodically reset to prevailing interest rates.

Top 3 performing Debt Mutual Funds

1. ICICI Prudential Liquid Fund: The fund generated returns of 7.22% and 7.91% over the last 3 and 5 years respectively. The fund’s returns are higher than both the CCIL T Bill Liquidity Weight which generated returns of 4.30% and 4.84% over the last 3 and 5 years respectively as well as the entire liquid fund category which generated returns of 6.94% and 7.71% over the last 3 and 5 years respectively.

The YTM (Yield to Maturity) of the fund is 7.12% and its expense ratio is 0.22%.

The modified duration of the fund is 0.09 years.

ICICI Liquid fund offers the benefit of instant redemption wherein you can get redemption value credited to your bank account within 30 minutes. You can choose direct plans to save on distributor commissions and the growth option. The growth option can result in lower tax liability than the dividend option if you are in the 10% or 20% tax bracket.

2. Franklin India Short Term Income Plan (Retail): The fund generated returns of 7.91% and 8.96% over the last 3 and 5 years respectively. Over both the tenures, the fund outperformed both the CCIL T Bill Liquidity Weight which generated returns of 4.30% and 4.84% over the last 3 and 5 years respectively and the entire short duration fund category which generated returns of 6.80% and 7.69% over the last 3 and 5 years respectively.

The YTM (Yield to Maturity) of the fund is 10.68% and its expense ratio is 1.57%.

The modified duration of the fund is 2.03 years.

3. Axis Liquid Fund: The fund generated returns of 7.26% and 7.93% over the last 3 and 5 years. This debt fund also outperformed both the CCIL T Bill Liquidity Weight which generated returns of 4.30% and 4.84% over the last 3 and 5 years respectively as well as the entire liquid fund category which generated returns of 6.94% and 7.71% over the last 3 and 5 years respectively.

The YTM (Yield to Maturity) of the fund is 7.51% and its expense ratio is 0.15%.

The modified duration of the fund is 0.12 years.

If you would have considered a SIP of Rs. 1,000 for a period of 36 months starting October 2015 to September 2018 in any of the above mentioned top 3 debt funds, then the value of your investment as on September 30, 2018 would have been as under:

Fund Name

1 Year Returns

3 Year Returns

5 Year Returns

Value of Rs. 1,000 SIP for 36 months

ICICI Prudential Liquid Fund

7.11%

7.22%

7.91%

Rs. 40,162

Franklin India Short Term Income Plan (Retail)

6.03%

7.91%

8.96%

Rs. 40,563

Axis Liquid Fund

7.20%

7.26%

7.93%

Rs. 40,204

(All mentioned data is as on October 15, 2018; Source: Value Research)

Tax Treatment of Debt Funds

Dividends and capital gains earned on mutual funds are taxed differently. Dividends are not taxable in case of debt funds after the investor receives them. However, a dividend distribution tax is payable directly by the fund house to the government before it reaches the investor and this is included in the expense ratio of the fund. With respect to capital gains tax, this is taxable in the hands of the investor.

Capital gains can be taxed as short term capital gains or long term capital gains depending on how long units of the debt fund were held prior to being redeemed or switched. Debt fund profits come under the purview of short term capital gains in case the fund’s units have been held for less than 3 years from the date of unit allotment before they were redeemed or switched to a different scheme. These short term gains are taxed according to the investor’s income tax slab. Such profits are included in the annual income of the investor under the income from other sources head in the ITR form.

Long term capital gains in case of debt funds occur in case units of the mutual fund have been held for over 3 years from the date of allotment prior to being switched/ redeemed. Long term capital gains for debt funds are taxed at 20% with indexation. You can find out more about this here.